Can China’s New Leaders ‘Revolutionize’ With Financial Reforms?

Reforming China's financial sector, regarded as essential for sustaining strong economic growth and a rise in domestic demand, looks likely to be a top priority for China's new leadership.

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In fact, in his opening speech to the ruling Communist Party's national congress on Thursday, China's outgoing President Hu Jintao confirmed that financial reforms would be high on the government's agenda.

Beijing has already stepped up its commitment to financial reforms this year, with a slew of measures including widening the yuan's trading band against the U.S. dollar, raising the investment cap for foreign companies in domestic securities firms and increasing bank flexibility in setting rates for deposits and loans.

Economists believe the pace of reforms will quicken in the coming years, with HSBC'S chief China economist Qu Hongbin anticipating a swathe of reforms that will "revolutionize" the country's financial system.

"There are clear signs that China's new leaders, who will take power in early 2013, will make speeding up reform top of their policy agenda in the coming years," said Qu.

China is expected to announce its new line-up of leaders at the end of the national congress next week.

Granting banks more freedom to set lending and deposit rates, growing the bond market and additional steps to make the yuan fully convertible by loosening currency controls further will be the key focus of reforms under the new leadership, say analysts.

"These changes would not only make capital allocation more efficient, boosting the private sector, but also provide the middle class with greater choice about where to put their money so they can earn a higher return and therefore spend more," Qu said.

The People's Bank of China began the process of interest rate liberalization in June, giving lenders the flexibility to set interest rates for consumers.

For the first time, the central bank allowed banks to offer depositors interest rates up to 10 percent higher than the benchmark rate and loans at up to 20 percent below the benchmark rate, compared with 10 percent previously.

The reform allows market forces to play a greater role in capital allocation and will help shift the balance of the economy towards consumption as higher bank deposit rates would give households more spending power and higher lending rates would reduce excess investment, Qu said.

Bond Market Growth

Expanding China's bond market, which is critical for reducing the concentration of financial risk in the banking system, is also expected to be an important goal for policymakers.

Lending by banks represent over 75 percent of total social financing - a broad measure of funds raised in the economy – in mainland China, reflecting a heavy reliance on bank funding. Around 60 percent of the massive stimulus package launched by Beijing in 2009, for example, was funded by bank credit, according to analyst estimates.

China must shift its economy away from an overreliance on bank funding, and create other financing options for corporates, said Zhang Zhiwei, chief China economist at Nomura.

"State-owned enterprises have been crowding out the private sector, attaining more bank loans at lower interest rates, and filling up banks' loan quotas," said Zhang, adding that further development of the bond market would help level the playing field for corporates.

Policymakers have begun to speed up the development of the bond market, introducing pilot programs for municipal and high-yield bonds.

Last year, Beijing selected four local governments to begin issuing bonds in order to raise revenue. In June, China began a program allowing smaller companies to sell high-yield bonds through private placements.

"We expect the expansion of municipal and corporate bonds to double the size of the domestic bond markets in the coming five years," Qu said.

Nicholas Consonery, China analyst at Euroasia Group agrees that the domestic debt market is poised for rapid expansion, judging by the "impressive growth in that market over the past couple of years."

Greater Yuan Freedom

Currency strategists say the government will continue moving towards greater flexibility in the yuan.

"There are more and more moves to full convertibility of the yuan, for instance the widening of the renminbi trading band this year, was one of those steps," said Hamish Pepper FX Strategist at Barclays. "Eventually we will see the band widen further, there's a desire from the Chinese authorities to see greater two-way volatility in dollar-yuan."

(Read More: China Cabinet Seeks Ambitious Economic Reform Agenda)

In April, China widened the trading band of the yuan, allowing it to rise or fall 1 percent from its mid-point, from a previous limit of 0.5 percent – marking a shift towards a more market-oriented regime.

The need for a fully convertible currency is building, added Pepper, as the global use of the yuan as a trade settlement currency rises. The renminbi represented 9 percent of total trade in 2011.

China's policy on the yuan - which was pegged to the U.S. dollar until 2005 - has been criticized by U.S. politicians, who have accused Beijing of maintaining anartificially low currency to boost exports.

However, the pace of yuan appreciation has picked up and the currency has risen almost 2 percent against the dollar since September -helped by the latest round of monetary easing by global central banks.

Ten years down the road and China's financial sector will look very different as a result of the expected slew of reforms, said Kumar Palghat, managing director at Kapstream Capital.

"Lots of things can happen in the next 10 years, there is a high possibility they could free up the currency, if they free up the currency then does it become a reserve currency? If the currency is fully convertible, how big does the bond and equity market become? This is massive for us," Palghat said.